Capital Asset Pricing Model Assistance

Explain how the CAPM assists in measuring both risk and return.
Explain how the CAPM assists in calculating the weighted average costs of capital (WACC) and its components.
Illustrate why some managers have difficulty applying the Capital Asset Pricing Model (CAPM) in financial decision making.
Identify the benefits and drawbacks of using the CAPM.

Solution Preview

Explain how the CAPM assists in measuring both risk and return.

The capital asset pricing model (CAPM) is used to calculate investment risk and what return on investment one should expect by providing a usable measure of risk that helps investors determine what return they deserve for putting their money at risk. The model states that investments contain two types of risk:

1. Systematic risk - These are the market risks that cannot be removed through diversification, such as interest rates, recessions and wars.

2. Unsystematic risk - These risks are specific to individual stocks and can be removed through diversification by increasing the number of stocks in one's portfolio.

CAPM is used as a way to measure and deal with systematic risk in order to maximize return. According to the model, beta is the only relevant measure of a stock's risk, or volatility, by determining how the price of a specific stock increases or decreases as compared with how much the stock market increases or decreases. When beta is compared with the equity risk premium, it shows the amount of compensation equity required by investors for taking on additional risk. By knowing the individual components of CAPM, it is possible to determine whether or not the current price of a stock is consistent with its likely return. The model basically states that the only reason an investor should earn more on average by investing in one stock rather than another is that one stock is riskier (Mullins, 1982).

Explain how the CAPM assists in ...

Solution Summary

Capital asset pricing model assistance is examined.The benefits and drawbacks of using the CAPM is determined.